Friday Market Thinking
June 20, 2020
The markets had a choppy week as the noise trader equity rally ran out of steam and reversed somewhat, before the Fed once again provided support, this time through direct buying of US corporate debt. In some senses this removes default risk from US Corporate debt in a similar way to the earlier ECB buying measures did in Europe, although we suspect its main purpose is to prevent a wave of Post Covid downgrades triggering a flood of ‘new’ junk bonds and overwhelming the markets. That support not notwithstanding, not only is macro sovereign risk rising, but also idiosyncratic or stock specific risk is also rising and active management now more than ever requires both bottom up knowledge and research and a proper methodology around portfolio risk management and diversification. Events this week such as Wirecard and the problems around the ‘alternative’ lending models backed by the Credit Suisse bond funds – and yet more trouble for the hapless Softbank – are only the start of what looks like being a tough summer.
Short Term Uncertainty
This week was characterized by some weakness at the start as the traders pushed a negative narrative to try and shake out the weak hands in the day trading stocks, only to be followed by a rebound as the Fed moved to further support the US Corporate Bond market by buying US corporate bonds directly rather than just supporting the Credit related ETFs. In doing so they moved to the same strategy as the ECB in effectively guaranteeing US corporate debt – which led us to wonder in the blog what is the point of rating agencies any more? This Fed move nevertheless managed to further reduce both short term uncertainties and medium term risk and if, as we suspect, asset allocators and long term investors have been ‘buying the dips’ in equities and high yield bonds, then the rally from the March lows will remain supported.
If we look at the latest ETF fund flows from Bloomberg, we can see a clear pattern of rotation out of low volatility into ‘Value’ the week ending June 15 which tends to support our asset allocator buy the dips view.
Flows into Factor ETFs
Medium term Risk
Covid-19 is increasing idiosyncratic risk
If the main news in markets is how the Fed are supporting the US corporate bond markets, then we should not lose sight of the fact that other corporate and indeed sovereign debt is not so favoured and that weak balance sheets are exactly the sort of ‘pre-existing conditions’ that render companies vulnerable to the financial equivalent of a Cytokine storm in the wake of the Covid-19 privations on cash flow and business activity. This week for example, we note that Fitch followed Moody’ and S&P in downgrading India to one notch above junk. Meanwhile, the end of the week saw the spectacular collapse in the share price of Wirecard, whose market cap of Eur2.5bn is now around 1/10th of its previous peak.
Although this appears to have been a fraud and nothing to do with Covid-19, it has highlighted the increased idiosyncratic or stock specific risk in a number of active portfolios. As previously discussed, in order to get a better return than the benchmark, active managers have to take different risks, some of them often obscured from the underlying investors. So as the FT and other papers are reporting today, a number of funds had very large, as in 10% or more of their fund positions in Wirecard. One, former Jupiter European Opportunities manager who had made his reputation largely on the back of Wirecard’s rise, had an exposure of over 17% in the stock at one point. This had fallen to around 10% by January, but only thanks to the stock falling sharply at the end of last year after a report in the FT suggesting that much of the company’s revenues were non existent! He now describes it as his “biggest mistake”. Meanwhile, a group of fund managers at DWS in Germany had bought over Eur500m of the stock for their portfolios immediately after that FT report. As ever, the question has to be “where were the risk managers?”
On the other side of the trade were some well known short sellers such as Hedge Fund TCI, who sent an open letter back in April, demanding that the CEO resign. At that time only 3% of analysts monitored by Bloomberg had a sell on the stock and the share price was Eur140. You couldn’t actually sell the stock short at the time as the German regulators had put a stop on short selling- although you could have bought the June 80 puts for Euro 1.94. Indeed the price quickly dropped to around the 80 level. On Friday the puts were trading at Eur 54.2. Nice work if you can get it.
There are several points here. Firstly, that we should be extremely vigilant about balance sheet and cashflow ‘concerns’ and certainly after a report such as the FT one, there should have been a much higher idiosyncratic risk premium put on a stock. Second, the point of portfolio constructions is to diversify away even ordinary levels of idiosyncratic risk, let alone heightened ones. This, rather than the mistake of ‘getting the company wrong’ should be the focus. The former Jupiter managers apparently said in a letter to investors in January “I might remind you I invest in companies – not stock – and the point about wirecard is it’s a great company”. This should have been a big red flag, but wasn’t. He absolutely is investing in a stock not a company because that is the job of a portfolio manager, to put together a diversified portfolio of stocks that offer an attractive trade off between risk and return. If he, or the DWS managers had run more balanced positions – which is not to say that they have to hug a benchmark – then their investors would have been better protected.
Covid is exposing all sorts of fault lines and some apparently successful business models are part of that process. This is not unusual, hence the famous Buffet quote about “when the tide goes out you can see who has been swimming naked” and very often it is the people who have had some of the greatest apparent success that turn out to have feet of clay. There used to be an old rule of thumb that you shouldn’t invest in a company with a fountain in its foyer or where the chairman drove a Rolls Royce. An updated version might include anyone who had just bought several private jets, or owned two floors of the Burj al Arab in Dubai, or who had somehow taken an old and not very profitable business and gained enormous and apparently highly profitable market share winning awards as an entrepreneur and ‘disruptor’ in a business with low barriers to entry. To that we might also perhaps add anybody that just got a few hundred million of investment from SoftBank.
The news then in the FT this week that SoftBank’s Vision Fund had been investing in Credit Suisse’s so called supply chain funds that in turn invested in some of VisionFunds own start-up companies has raised plenty of eyebrows but probably shouldn’t come as a surprise. Nor the fact that these funds are blowing up rather badly. Basically SoftBank also invested in the ‘disruptor’ start up bank Greensill that facilitated the structuring of the funds themselves. Briefly, the idea is simply a form of reverse ‘factoring’, instead of buying a company’s receivables (factoring) they settle their working capital debts early in return for a spread. Suppliers are happy to accept a discount in order to get paid quickly and the reverse factor provider effectively becomes a creditor to the company. The risk, as ever, with what is essentially banking, is credit risk and default and just as in the latest WWW we discussed liquidity mismatch, so we find that when traditional banking is replaced with some form of securitization, that the focus on credit risk is often lost in the pursuit of volume. When times are good the business looks great – and certainly former Morgan Stanley Banker Lex Greensill will have celebrated winning the EY Australian Entrepreneur of the year 2018 (tick) in some style, doubtless on one of his 4 private jets (tick) as detailed in this story from last December.
But we have all seen this movie and it won’t be much of a surprise to hear that it has all unravelled fast – almost as fast as SoftBank’s star pupil Won’tWork. In particular the bank has had issues with its short term loans business, being hit by defaults from Indian Billionaire and owner of two floors in the Burj (tick) BR Shetty’s NMC healthcare, where, as short seller Muddy Waters identified, the liabilities to the supply chain fund through the reverse factoring were obscured to present a false picture of corporate health and, allegedly, the funds diverted to other Shetty companies.
Interesting that the linked Bloomberg story from December also mentions that Greensill and by extension Credit Suisse/GAM had (quote) ‘many clients in the “non-investment grade supply chain space,” according to Greensill. Riskier companies typically pay more for financing. Customers include U.K. industrialist Sanjeev Gupta’s GFG Alliance, a debt-laden metals conglomerate; Shop Direct, part of the Barclay brothers’ struggling business empire; and BrightHouse Group Plc, a loss-making rent-to-own retailer.’
No surprise, all of the companies mentioned are in trouble and the underlying investors in the Credit Suisse Funds are taking the hit with redemptions shrinking the Credit Suisse Gam funds by 25% last month. Worth pointing out here perhaps the above mentioned Sanjeev Gupta’s (Private jet, tick) GFG Alliance Bonds were at the heart of the scandal last year that saw GAM’s Absolute Bond Fund manager Tim Haywood, another fund manager previously seen as ‘a star’ to resign abruptly. https://www.ft.com/content/56e5b0ba-39ed-11e9-b856-5404d3811663
Seemingly undeterred, Lex Greensill (who incidentally employs former UK Prime Minister David Cameron as an advisor..that’s probably another tick) has just announced plans to expand in Latin America via an all share deal to buy a business in Columbia. That should be interesting to say the least! Oh and as a final point, there was a short squeeze in Wirecard stock back in April – that probably prompted the TCI letter – which was largely down to news of a complex deal that would have delivered a strategic stake of just over 5%….to Softbank.
Model Portfolio Performance 70:30 Fund
This is a new feature for Friday Market Thinking, a brief discussion of the behaviours and performances of our main Model Portfolio, the 70:30 Fund. This is a ‘blend’ of our two main underlying funds, the Global Equity Fund and the Global Bond Fund.
5 Day Return: -1.35% (06/10/20 – 06/16/20)
Best One Day Return: 2.04% (06/16/20)
Worst One Day Return: -1.89% (06/11/20)
Benchmark (70% MSCI World Index + 30 % Bloomberg Barclays Global-Aggregate Index)
5 Day Return: -1.80% (06/10/20 – 06/16/20)
Best Day Return: 1.6% (06/16/20)
Worst Day Return: -3.61% (06/11/20)
- On 11/6, the global markets were down due to concern over a second wave of Covid-19 outbreak, seeing the rise in cases in the last couple of weeks. Our portfolio got hit inevitably, on that day, the Equities portfolio was down by 2% while it was buffered by the Fixed Income portfolio’s slight increase of 0.11%, still resulted the worst daily return over the week, -1.89%. However, our portfolio benchmark, which is also a balanced blend of both equities and fixed income across the globe, was down by 3.61% on the same day, demonstrating our portfolio’s holdings are notably less prone to sudden market headwind.
- The market concern was soon relieved after the FED announced that it would hold interest rate unchanged at least through 2022 and offer more measures, such as stepping up the bond buying, to support the economy, the portfolio then showed recovery and gave a best day return of +2.04% on 16 Jun.
- Looking at the bottom 5 contributors to performance over the week in global equities and bonds, and the relative fund flow around the same period discussed earlier, we can see in the Smart Beta Universe, the ones showing negative fund flows are mostly the bottom contributor in our portfolio, namely Size, Quality, and Low Volatility. From flow, it looks like they are being switched into value. The fact that this factor has actually fallen this week is likely down to the strength of the rally in recent weeks from the lows. We would likely expect consolidation now rater than full reversal.